Okay, Here's One Way Geithner's Capital Conversion Plan Could Help

Although
we joined the ranks of critics of Treasury Secretary Tim
Geithner's latest plan to bailout banks that fail stress tests by
converting the government's preferred equity shares into common
stock, we'll acknowledge that there is one way that the plan
could help things.

The conversion could improve operating incentives at banks that
fail the stress tests, economist Linus Wilson explains. Bank
executives will be incentivized to improve performance since
having more common equity and less preferred would mean that
executives could capture more of the profits. Under a structure
with a huge amount of preferred stock, so much of the gains are
taken by junior creditors that executives are likely to respond
in one of two ways: underperforming because their upside is so
limited or ramping up risk in hopes of earning enough gains that
they can capture some upside. Neither is healthy for the
financial system.

"These poorly performing banks probably should also raise new
common equity," Wilson explains.

"Yet, my research indicates that banks that would do poorly on
something as easy as the Fed’s stress tests will resist issuing
new common stock because too much of the gains from issuing new
common stock are realized by their junior creditors.
Issuing new common stock in potentially insolvent banks reduces
the default risk on subordinated debt. The stock price
would probably fall substantially after a seasoned equity
offering is announced for banks failing the stress test because
creditors gobble up a large chunk of the gains from such an
issue. Unfortunately, what is good for the financial system
is not necessarily good for the current shareholders of the
banks, which should have been better prepared for the stress
tests. This is probably why these poor performers may find
the subsidized finance of the TARP a more attractive alternative,
despite the strings attached to the government’s money."

In short, the conversion may be the only way to get new common
equity into the banks and new common equity may be the key to
making the banks healthier. This new health, however, would come
from better performance incentives rather than through what is
essentially accounting smoke-and-mirrors changes to the capital
structure. The key to this is that the capital structure effects
the incentives of the executives at the bank.